Worldwide: The Role Of Offshore Jurisdictions In Russia

This paper will examine the interaction between offshore jurisdictions and Russia, with particular emphasis on the role played by the British Virgin Islands in structuring offshore transactions. This paper will look at popular narratives about offshore jurisdictions, including traditional arguments about round-tripping and corruption, before examining the legal rationale for the use of offshore structures in Russia. It will be argued that the use of offshore jurisdictions arose as a response to deficiencies in the Russian legal system, particularly in terms of Russian law as it relates to property rights, and the related problem of enforcing such rights. In contrast to these perceived deficiencies in the Russian legal framework, offshore jurisdictions provided a stable and modern legal environment, the use of which allowed Russian investors to gain access to Western common law principles of corporate governance, property rights and shareholder rights.

Introduction

This article will examine the use of offshore jurisdictions in Russia, with particular emphasis on the role played by the British Virgin Islands [hereinafter BVI]. The objective of this paper is to understand the reasons behind the popularity of offshore structures in Russian commerce, and to shed some light on the legal rationale behind their use, by examining the interplay between Russian and offshore legal systems.

This is an important area for study, given the significant role that offshore jurisdictions play in Russian foreign direct investment [hereinafter FDI]. The prevalence of offshore structures in Russian FDI is well reported, and it has been observed that in 2012, 11 of the main 40 recipients of Russian FDI were offshore jurisdictions which were seen as acting as a transit platform for the movement of capital to other destinations. Of these offshore zones, three jurisdictions are the largest recipients of Russian FDI, being the BVI, the Cayman Islands and Cyprus. These three jurisdictions have played host to increasing and significant volumes of Russian financial flows, with the growth of outward FDI stocks in Cyprus growing from $206 million to nearly $4 billion in the period between 1998 and 2006, the BVI increasing from almost zero in 1990 to $123.5 billion in 2006 and the Cayman Islands increasing from almost zero to $40.4 billion in the same period.

Given the popularity of offshore finance centres, and the significant FDI flows passing through such jurisdictions, the question then arises as to why offshore structures have been used in Russia. Unfortunately, this is an area in which there is a lack of significant academic analysis and the few studies that address the topic simply focus on questions of tax avoidance, round-tripping and corruption. T he legal rationale, practical use and function of offshore structures are rarely considered. This is a significant deficiency in the existing literature on the topic as legal concerns have been a key consideration behind the use of offshore structures in Russia.

This paper will therefore attempt to redress this deficiency and cast some meaningful light on the role of offshore jurisdictions in Russia, by looking to the legal rationale for the use of offshore structures. It is only by looking at the actual use of offshore structures in practice, and the legal environment which gives rise to their use, that we can achieve an understanding of the purpose behind such structures. In order to understand the rationale behind the use of offshore structures, this paper will examine the ways in which the use of offshore jurisdictions arose as a response to certain deficiencies within the Russian legal system and the difficulties faced by Russian enterprises in accessing international finance. This paper will argue that offshore jurisdictions, such as the BVI, have been used as a platform to overcome legal inefficiencies in the Russian legal system and to manage legal risks in the face of an uncertain political and economic environment.

The rest of this paper is divided into three further sections which consider: (i) common narratives and popular misconceptions about the role of offshore jurisdictions in Russia; (ii) the historical and legal context to property rights in Russia; and (iii) the legal rationale for the use of offshore jurisdictions.

2. Common Narratives about the Role of Offshore Companies in Russia

Before looking at the legal rationale behind the use of offshore jurisdictions in Russia, it will be useful to examine the existing literature in this area in order to understand the popular narratives and misconceptions which frame analysis on this topic. This is important given that most studies in this field assume that offshore structures are either used for the round-tripping of funds or for laundering the proceeds of corruption. It is notable that the studies in this area do not address the legal rationale for the use of offshore structures. As a result, the exclusion of legal issues from this discourse creates an imbalanced and incomplete picture of this topic. Therefore, before looking at the legal context, any discussion of this topic must first consider and address these popular narratives.

2.1. Round-Tripping Claims

The most common argument made about offshore jurisdictions is that they are used to facilitate the round-tripping of funds. Round-tripping is essentially a process whereby funds are moved overseas and then re-routed into Russia through the use of offshore vehicles, which thereby mask the original source of the funds. The traditional rationale given for round-tripping is that, by disguising Russian sourced capital as 'foreign' through the use of an offshore company, the Russian investor will have access to tax or regulatory benefits that are usually reserved for foreign investors.

The round-tripping thesis is commonly held by observers of Russian FDI patterns, although the assumptions underlying this theory are often undeveloped. For instance, one study states that 'according to data from the Bank of Russia, Bermuda, the British Virgin Islands and Cyprus were the three largest sources of FDI in Russia as of 2010. This reflects the importance of round-tripping Russian investments via tax-haven destinations.' However, no source is provided for the claim that offshore FDI statistics reflect the importance of round-tripping, nor is this point elaborated further. It is simply accepted as fact. This is unfortunately a common problem in this area of study, as many observers adopt the same approach and take the round-tripping argument as orthodoxy, without support or considered analysis.

A further problem with this approach is that the round-tripping thesis may not be an appropriate tool with which to understand Russian FDI patterns. For example, the round-tripping argument is generally founded on studies concerning the People's Republic of China [hereinafter PRC] where it is commonly argued that PRC investors route funds through offshore companies in order to gain foreign investment benefits. However, Russia has not given preferential tax and regulatory treatment to foreign investors in the same way as the PRC, so some caution is required in relying upon such theories when considering the Russian investment environment. This concern has been expressed by some observers, with one paper noting that, in contrast to the investment environment in the PRC,

Not only is it unsuitable to apply concepts of round-tripping as they relate to the PRC to the Russian experience, but it may also be inappropriate to overstate this concept at all. For instance, the theory rests upon the assumption that the money being routed through offshore centres is Russian money being repatriated through offshore channels. However, this fails to account for the fact that other jurisdictions use the BVI to structure their financial transactions as well as to effect investment into Russia. For instance, a report by the Carnegie Moscow Centre noted that 'Chinese companies often invest abroad through the British Virgin Islands. The investment from the British Virgin Islands is quite substantial in the post Soviet space including Russia. It can be assumed that part of these investments in fact come from China.'

Additionally, it should be noted that other studies have examined the use of offshore jurisdictions (particularly in the Chinese context) and observed that round-tripping is not a significant or sole explanation for the use of offshore structures in FDI patterns. Instead, it has been observed that '[t]ax minimisation through the Caribbean offshore thus seems to be less a motivating factor than property rights, investment seeking and institutional arbitrage.' These other factors are important to bear in mind because offshore jurisdictions perform other roles than tax structuring. As Vlcek notes, '[t]he common portrayal of the [offshore jurisdiction] today as a tropical island "tax haven" fails to acknowledge that it provides other forms of regulatory arbitrage beyond taxation. It may be the home to mutual (hedge) funds, captive insurance and re-insurance firms, trust companies, and shipping registries, as well as an international business company (IBC) registry.' As a result, consideration needs to be given to other factors rather than relying upon undeveloped notions of round-tripping. It will be seen later in this paper that these same motivating factors of property rights, investment seeking and institutional arbitrage, apply equally in the Russian context.

2.2. Corruption Claims

Aside from the round-tripping argument, another common assumption that underlines many studies is that offshore structures are used in Russia for the purposes of laundering the proceeds of corruption.

A number of papers approach this topic through the lens of criminality and assume, as their starting point, that offshore companies are used by Russian investors for corrupt purposes. A good example of this perspective can be seen in a paper by Ledyaeva, Karhunen, Kosonen and Whalley, who assert that the drivers for the use of offshore jurisdictions in Russian capital outflows 'mainly include tax avoidance / evasion, laundering the proceeds of corruption and securing the secrecy of an investor's identity from Russia's corrupt and autocratic authorities.' These are strong charges, and the crucial point to note is that, after making sweeping claims as to the nature of offshore transactions, no source or authority is provided for such assertions. Instead, these claims are posited as an assumed starting point for analysis, on which the research is based, rather than a conclusion reached through neutral research and, consequently, no attempts are made to analyse and test these assumptions.

Similarly, Ledyaeva, Karhune, Kosonen and Whalley assert that given 'the persistently high-level of corruption in Russia, it is reasonable to suggest that corrupt public officials in Russia utilize round-trip schemes via offshore centres for laundering the proceeds of corruption.' Again, no specific source, authority or foundation is provided for such claims. This approach is therefore troubling, as it operates to ascribe a character of criminality to offshore jurisdictions by association rather than through fact, and is based upon supposition rather than analysis. Without hard facts, it is not 'reasonable to suggest' that offshore structures are used for the purposes of laundering the proceeds of corruption. Suggestion is not a sufficient ground on which to conduct analysis or perpetuate myths.

If serious claims are going to be made about the nature and role of offshore jurisdictions, they need to be supported by fact and reasoned analysis. The question then arises as to how, if these types of assertions are accepted, we can test and verify such claims.

One answer is to look to the courts as a source of fact. If offshore structures are used, as some authors suggest, for the purpose of laundering the proceeds of corruption, then these structures, and any claims or evidence of impropriety in respect of such structures, will ultimately come before the courts. As a result, the courts would also provide a key source of factual evidence to support such assertions. If these assertions are correct, then one would expect to see a significant number of court judgments concerning allegations of corruption and criminality.

In order to test these theories, research was conducted on all the judgments available at the Eastern Caribbean Supreme Court, where such judgments were made by the BVI courts and either concerned Russian parties or related Russian business or assets. The BVI was used as a sample jurisdiction given that it is the leading offshore jurisdiction within Russia in terms of FDI flows. In addition, the BVI has a robust legal system and a dedicated commercial court, ensuring that there would be a wide and easily available selection of judgments to review.

This research found that there were 41 relevant judgments concerning Russian parties or enterprises located in Russia. Of these judgments, there were 7 cases in which fraudulent, dishonest or unlawful conduct was alleged, amounting to 17% of all judgments. Of these 7 cases, there were no judgments in which fraudulent, dishonest or unlawful conduct was proven to the satisfaction of the court. What this research clearly shows is that corruption is not a significant issue before the courts in terms of the use of offshore structures in Russia, given that only 17% of cases alleged such issues and that in no case was any allegation of fraudulent, dishonest or unlawful conduct proven. Based on this review of BVI cases, there is simply no grounding in proven fact or law to justify the corruption allegations raised by some academics and journalists.

The question then arises as to why some authors persist in ascribing notions of criminality to offshore structures in Russia, when there is clearly a lack of analysis underlying such assumptions and an absence of factual grounds to support these assertions. It would tend to suggest that some of the existing studies and journalistic reporting on this topic are unsound. It would also suggest that many studies may be tinctured by an inherent bias on the part of the observer.

The question of bias is important, as the fact that these claims are made on the basis of assertion rather than supported fact suggests that common perceptions on the use of offshore structures in Russia is informed by value judgments. In a sense, it can be seen that many observers of Russian business operate with innate or unconscious anti-Russian bias, where it is assumed (rather than established) that Russian commercial practices must necessarily involve corruption. T his bias therefore infects popular perceptions towards the use of offshore structures in Russia as, given the lack of understanding of the legal and commercial rationale behind the use of such structures, an assumption is made that their use must simply be a product of nefarious intent.

It can be seen that this anti-Russian bias has a long history and arises frequently where Russian business practices are involved. To take one example, this bias could be seen in relation to the failed bid by the Russian company Severstal for Arcelor where The Wall Street Journal reported that there was a 'mounting frustration in Moscow at a perceived anti-Russian bias in European business' and The New York Times similarly reported that 'many Western investors still look at Russia in "comic book terms, as mysterious and mafia-run".' Given the narratives concerning the use of offshore jurisdictions in Russian FDI, it would appear that this comic book characterisation also extends into journalism and academic analysis. This frustration is shared by some contemporary observers of Russian FDI. For instance, one paper notes that there were problems with creating 'a positive and attractive image of Russian business abroad [due to] the extendedly created politicised typologies of Russian multinationals' and another paper observed that Russian investors face 'a strong degree of suspicion in most parts of Eastern Europe and in the developed world . . . [even though] Russian investors have frequently transformed bankrupt enterprises into thriving companies and are regarded as effective owners and employers.'

Aside from questions of bias, many studies also exhibit a lack of understanding as to the nature of offshore transactions. For example, many studies fail to address the legal rationale for the use of offshore jurisdictions, despite the fact that offshore structures are created in a legal context (given that offshore companies are creatures of law, created for legal purposes and governed by legal rules). This is an important consideration and, again, an examination of the BVI court judgments gives insight as to the real concerns surrounding offshore structures. An analysis of the court judgments relating to Russia reveals that, rather than criminal enterprise, the main concerns before the courts related to property rights, shareholder disputes and questions of corporate governance. The types of structures under consideration were joint ventures, holding companies and investment vehicles. In most cases, these were ordinary commercial disputes concerning normal business activities and standard types of investment structures that one would expect to see in a normal and mature legal environment.

The rest of this paper will therefore dispense with the bias and unreliability of common narratives about offshore jurisdictions and instead show how a legal analysis is essential to understanding the role that offshore structures have played, by looking at aspects of the Russian legal system that gave rise to the demand for offshore vehicles and aspects of offshore jurisdictions that made them suitable for use by Russian investors. The Paper will explore how the need for legal certainty has been a key driver of the use of offshore jurisdictions, which has been an issue of key importance given historical deficiencies and uncertainties in Russia's legal and financial infrastructure.

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Previously published in the Russian Law Journal.

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